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Friday, October 21, 2011

Variable Electricity Prices

Traditionally, households were billed for electricity at a flat rate. You could make investments in energy conservation, and the savings would be the quantity of electricity saved multiplied by that flat rate. But in the wholesale market, electricity rates fluctuate a great deal. When demand is highest, the system operators need to bring expensive "peaking" power plants on-line, and prices jump. With new "smart meter" technology, it is becoming possible for consumers to react to these fluctuations in electricity prices. In "Dynamic Pricingand Its Discontents" in the Fall 2011 issue of Regulation magazine, Ahmad Faruqui and Jennifer Palmer offer a nice readable overview of the possibilities. If you're teaching a basic economics class and looking for a nice vivid modern real-word example of consumers adjusting to price changes that doesn't involve hypothetical pizzas and haircuts, electricity pricing might be a good choice.

Here's the underlying issue that causes wholesale electricity prices to fluctuate: "Since electricity cannot be stored and has to be consumed instantly on demand, and since demand fluctuates based on lifestyle and weather conditions, the electric system typically has to keep spare “peaking” generation capacity online for
times when demand may surge on short notice. Often, these “peaking” power plants are only run for 100–200 hours a year, adding to the average cost of providing electricity. Dynamic pricing incentivizes electricity consumers to lower their usage during peak times, especially during the top 100 “critical” hours of the year, which can account for anywhere from 8 to 18 percent of annual peak demand."

Smart meters are coming: "By 2015, according to the Institute of Electric Efficiency, about half of the nation’s 125 million residential customers will have smart meters. The institute anticipates that by 2020, nearly all customers will be on smart meters. Thus, a major technical barrier to dynamic pricing should be lifted in the next five to 10 years."

Consumers respond when faced with variable prices: "However, almost all analyses of pilot results show that customers do respond to dynamic pricing rates by lowering peak usage. Indeed, in 24 different pilots involving a total of 109 different tests of time-varying rates — covering many different locations, time periods, and rate designs — customers have reduced peak load on dynamic rates relative to flat rates, with a median peak reduction (or demand response) of 12 percent.... In other words, the demand for electricity does respond to price, just like the demand for other products and services that consumers buy."

Consumers who have better technology to adjust their electricity use react more strongly: "During the past few years, a variety of new technologies have been introduced to help customers understand their usage patterns (through web portals and in-home displays, for example), to automatically control the function of their major end-uses such as central air conditioning and space heating equipment (smart thermostats), and to manage all their other appliances and plug-loads (home energy management systems). ... Looking across all 39 pilot results with enabling technologies, the median peak reduction is 23 percent, 9 percentage points
higher than the median across all 109 results."

Many low-income customers would benefit from dynamic pricing: "Some people speculate that because low-income customers typically use less power, they have little discretion in their power usage and are thus unable to shift load depending on price. As a result, low income customers would be hurt by dynamic pricing.
However, empirical evaluation of this speculation has indicated that most low-income customers would immediately save money on their electricity bills from dynamic pricing. In general, when customers are placed on a revenue-neutral dynamic rate, we expect roughly half of the customers to immediately see bill increases and half to see bill decreases. Customers who use more load in the peak hours than the average customer would see higher bills, while customers who use less load in the peak hours than the average customer would see lower bills. ... Because the low-income customers tend to have flatter load shapes, roughly 65 percent of the low-income customers were immediately better off on the CPP [critical peak pricing] rate than on the flat rate. In other words, even without any change in electricity usage, more than half of low-income customers are better off on a dynamic rate."
Total savings? "At the national level, an assessment carried out for FERC twoyears ago showed that the universal application of dynamicpricing in the United States had the potential for quintupling the share of U.S. peak demand that could be lowered through demand response, from 4 percent to 20 percent. Another assessment quantified the value of demand response and showed that even a 5 percent reduction in U.S. peak demand could lower energy costs $3 billion a year."